Staying One Step Ahead of Distress

Fissures are appearing in the office market and may grow to yawning chasms in 2009 as layoffs accelerate. But the pain could deliver a long-awaited silver lining: Landlords that fail to cover their debt service or obtain refinancing will attract vultures and ignite investment sales.

“Everybody is waiting for the distressed and value-added plays,” says Arthur Milston, a managing director with Savills LLC, the U.S. arm of global real estate services firm Savills. “You haven't seen a big wave of distress hit the market, but investors intuitively know it's going to come.”

Indeed, office building sales totaled $48 billion through the first 10 months of 2008 compared with more than $185 billion during the same period last year, according to New York-based Real Capital Analytics, which tracks sales of $5 million or more. And the few active buyers are largely targeting trophy properties.

But private equity funds have raised tens of billions of dollars in anticipation of commercial property owners falling into distress. Real estate investment trusts (REITs), meanwhile, are boosting liquidity so they can pounce on opportunities as they surface.

“There are a couple looming out there, and there will be more as large loans come due beginning in 2009,” says Dennis Friedrich, president and COO of U.S. commercial operations for New York-based Brookfield Properties.

The REIT owns 75 million sq. ft. of offices in major U.S. and Canadian markets. “We've been shoring up our balance sheet to take advantage of the opportunities.”

Weakness looming

To date, office fundamentals are relatively healthy, but experts recognize that the tide is turning. Nationally, net office absorption swung to a negative 19.2 million sq. ft. in the third quarter of 2008 from a positive 16.2 million sq. ft. a year earlier, according to real estate research firm Reis.

Additionally, vacancy rose to 13.7% in the third quarter compared with 12.5% a year earlier. Although lease rates have flattened over the last few months, the third quarter's effective rent of $25.14 a sq. ft. was 4% higher than the same quarter in 2007.

The office market generally lags the health of the overall economy, however, which virtually ensures worsening fundamentals.

The U.S. economy shed 1.2 million jobs through the first 10 months of 2008, and more than half of those layoffs occurred in August, September and October. The Federal Reserve Board of Governors and Federal Reserve Bank presidents predict that unemployment could climb as high as 7.6% next year.

Diverging paths

The rash of layoffs has hit few cities harder than New York. In October, New York's comptroller estimated that Wall Street would cut 35,000 jobs, leading to a total of 165,000 layoffs in the city as businesses catering to financial firms also trim their workforce. That was before Citigroup's mid-November bombshell that it would cast off more than 50,000 jobs globally.

The sobering job losses illustrate how quickly fortunes can change, Friedrich notes. For years, New York was considered bulletproof. But Manhattan's office market experienced negative net absorption of 2 million sq. ft. in the third quarter without any new supply coming on line, according to Reis, and vacancy in the third quarter ticked up to 6.2% from 5.7% in the second quarter.

Yet Friedrich remains bullish on Manhattan and an investment strategy that centers on adaptable, supply-constrained markets. Brookfield owns about 19 million sq. ft. in New York, and Friedrich holds up Barclays' acquisition of Lehman Brothers within days of Lehman's failure as a measure of the market's resiliency.

While he recognizes that Manhattan's fundamentals will soften, Friedrich anticipates that other Brookfield markets such as energy-driven Houston and Calgary in Canada, and government-oriented Washington, D.C., will provide the company with growth over the next few years.

In fact, Washington, D.C., looks to be heading in the opposite direction of New York due in large part to the $700 billion bailout of financial institutions and expected policy changes that guarantee bigger government.

In early November, Brookfield inked World Bank Group to a 10-year lease for the entire 227,000 sq. ft. of the REIT's 1225 Connecticut Ave. in Washington, D.C. Brookfield owns nearly 7 million sq. ft. in the city.

“The election put some leasing activity on hold for much of the year,” Friedrich says, “but I think you'll see large leases getting done as we go into 2009.”